Banking system capitalization and systemic liquidity crises: Looking beyond the aggregate

This paper revisits the conventional wisdom that a better capitalized banking system is more resilient by examining the link between the capitalization of the banking sector and its resilience against systemic liquidity shocks. We build a model that endogenizes the amount of liquid assets that banks hold ex-ante and the extent of deleveraging that ensues after the realization of liquidity shocks. We uncover a novel inverted-U shaped relationship between the aggregate capital of the banking sector and its system-wide vulnerability. This finding implies that improving the banking system's capitalization in aggregate does not necessarily result in a more resilient system. Moreover, we find that the system's ability to withstand systemic liquidity shocks also depends on the cross-sectional distribution of capital across banks.

W show that banking system's resilience depends not only on the aggregate level of capitalization but also on the distribution of capital across banks. An aspect that has been overlooked by regulation.